Business costs you need to know: How do Fixed Cost and Variable Cost differ?

In business management, whether you’re a small entrepreneur or a large corporation, understanding the cost structure is indispensable because costs are the primary factor affecting the final profit. Pricing strategies, production planning, and the company’s competitiveness all depend on this understanding.

This article will introduce you to two key types of costs: fixed cost (and fixed costs) and variable cost (and variable costs), explaining their characteristics, origins, and importance in business decision-making.

Fixed Cost (and Fixed Costs) Are Unchanging Expenses

Fixed costs refer to expenses that remain constant regardless of whether the company produces a lot or a little, or even if it produces nothing at all. They are called “fixed” because these expenses do not change with production volume or sales.

It is important to remember that fixed costs are ongoing obligations that the business must bear. Therefore, financial planning must include estimates in advance to set selling prices that cover these costs and still generate profit.

Characteristics of Fixed Costs

Do not fluctuate with production volume - Whether production is high or low in any month, these costs stay the same every month.

Must be paid regardless - Even during periods of low sales, fixed costs still need to be paid.

Affect pricing decisions - Since fixed costs are unavoidable expenses, they must be included in the calculation of selling prices to ensure all costs are covered.

Examples of Fixed Costs in Business

Rent - Factory, office, or storefront rent paid regularly monthly or yearly, regardless of operational activity.

Salaries - Full-time employee wages that are fixed regardless of sales performance in a given month.

Business insurance - Property insurance, location insurance, liability insurance, etc., paid regularly as per the contract.

Depreciation - Depreciation of machinery, equipment, buildings, allocated based on calculated values.

Loan interest - Monthly loan interest payments, regardless of whether sales meet expectations.

Variable Cost (and Variable Costs) Are Dependent on Volume

Variable costs are expenses that change in proportion to the level of production or sales. As production increases, these costs increase proportionally; as production decreases, they decrease accordingly.

They are called “variable” because these costs are flexible and depend on operational activity, giving businesses more control over managing these expenses.

Characteristics of Variable Costs

Change with production volume - The more products produced, the higher these costs.

Flexible - Businesses can control these costs by adjusting production levels to match market demand.

Impact per unit - Reducing variable costs per unit increases profit margins per product.

Examples of Variable Costs in Business

Raw materials and supplies - The more products produced, the more raw materials need to be purchased.

Direct labor - Wages for temporary or piece-rate workers, depending on production volume.

Energy costs - Electricity and water used in manufacturing, increasing with higher production.

Packaging costs - Cost of boxes, bags, wrapping materials, proportional to the number of products made.

Transportation costs - Shipping expenses to deliver products to customers, varying with sales volume.

Commission - Sales team commissions based on sales volume; higher sales mean higher commissions.

How Do Fixed Costs and Variable Costs Differ?

Classifying costs is crucial for better decision-making, such as investing in new machinery (which will increase fixed costs) but reduce variable costs( to improve production efficiency.

Fixed Cost )Fixed Cost(

• Do not change with production volume
• Incurs regardless of operational activity
• Stable, making estimates easier
• Examples: rent, salaries, depreciation

Variable Cost )Variable Cost(

• Change directly with production volume
• Increase as production increases; decrease as production decreases
• Flexible, can be adjusted as needed
• Examples: raw materials, wages, energy

Total Cost Analysis )Total Cost Analysis###

Combining fixed and variable costs to analyze total costs is vital for various business decisions.

Calculating total costs - Summing fixed costs that do not change with volume and variable costs related to production volume to get an overall picture of expenses.

Benefits of Total Cost Analysis

Pricing - Helps set prices that cover all costs and generate profit.

Production planning - Assists in estimating optimal production levels for profitability.

Investment decisions - Evaluates returns on different investments.

Cost control - Identifies high-cost areas for improvement.

Risk assessment - Understands how market changes impact costs and profitability.

Summary: Why Understanding Fixed and Variable Costs Matters

Distinguishing between fixed and variable costs provides a strong foundation for effective business management. Whether you’re a business owner, manager, or financial analyst, this knowledge enables you to plan production wisely, set fair prices, control costs to maximize profits, and make informed investment decisions. Both fixed and variable costs play crucial roles in building a solid financial structure, directly influencing your company’s competitiveness and sustainable growth in today’s dynamic market.